Sunday, May 6, 2007
Broker-dealers have frequently sold Class B mutual fund shares to their customers instead of Class A shares because the higher Class B fees make it more profitable for the broker. In recent years NASD has brought many enforcement actions against securities firms for this practice and issued warnings to investors. The Sixth Circuit, however, recently dismissed a class action brought by customers purchasing at least $50,000 in mutual funds against Morgan Stanley for placing them in Class B shares, when, according to plaintiff (and accepted as true by the court for purposes of deciding the motion to dismiss) at this level of investment, Class A shares was always a better choice. The Robert N. Clemens Trust v. Morgan Stanley DW, Inc., 2007 WL 1263964 (6th Cir. May 2, 2007).
A bit of background: a customer's claim against his broker for an unsuitable recommendation is almost always brought in arbitration; generally, unsuitability claims are not amenable to class action because of the predominance of individual questions of fact such as the nature of the recommendation made by the broker to his customer and the individual investor's investment objectives (NASD rules exclude class actions from arbitration, one of the few exceptions to mandatory arbitration under the customers' agreement.) Plaintiffs occasionally attempt to bring class actions by alleging that their brokers engaged in common practices such as illegal business practices or widely disseminated misstatements that have the same impact on numerous customers. Plaintiffs' attempt to do so here, however, failed, largely because of the stringent pleading requirements of PSLRA. Specifically, plaintiffs (1) failed to state specific factual allegations that Morgan Stanley and its brokers knew or were reckless in not knowing that Class B shares were inferior to Class A shares; (2) failed to state sufficient facts to allow the court to draw an inference that MS knew that Class B shares were inferior to Class A shares; and (3) failed to state sufficient facts to establish that MS brokers knewe that Class B shares were unsuitable for plaintiffs. After all, the court reasoned, MS could have legitimately offered only the more expensive Class B shares, so how could it be fraudulent to offer their customers a choice? While recognizing hypothetically that MS could have engaged in a scheme to defraud its customers, the court did not believe that plaintiffs provided enough specific factual allegations facts that MS was steering its investors into Class B shares regardless of each investor's personal investment goals. In addition, it finds that plaintiffs abandoned their claims under Rule 10b-5(a) and (c) because they did not specifically refer to these subsections of the Rule in their opening brief.
As an investors' advocate, I have frequently argued that whatever the failures of SRO arbitration, it offers one great advantage to investors -- the arbitrators don't have to apply federal securities laws that have become increasingly anti-investor over the years. This case provides an excellent illustration for my argument. In arbitration a customer can base his claim on the unsuitability of the recommendation without having to establish scienter.
The 6th Circuit opinion is also noteworthy in that it is one of the few opinions (and perhaps the first from a federal appellate court) that cites an arbitration award to support its analysis. This is not a trend to be encouraged -- arbitrators do not have to apply the law, they do not have to give reasons, and arbitration awards have no precedential value -- the arbitrators' task is to resolve the dispute before them.